Archive: P/E Waves

U.S. economic growth in the opening quarter this year was the weakest in more than four years as businesses sold off inventories and Americans imported more foreign goods, the government reported on Thursday.

Corporate profits also, not surprisingly, tend to be correlated with business spending on technology. Hopes for a Microsoft (MSFT - Annual Report) Vista-inspired tech spending resurgence appear to have been dashed. While bulls argue that lower profits will require tech investments to spur productivity, the recent trend is for companies to do more with less. Therefore, I’d argue that there will be a smaller share of the smaller profit pie going to tech.

While consumption spending did rise as a contributor to GDP, the drag on profits may mean morelayoffs are in the pipeline, which in turn could put pressure on that consumption.

We have written before about long-term valuation cycles in the stock market. In fact, a key reason for our overall cautious outlook is that we believe we are currently in the middle of a long-term valuation contraction in which price/earnings multiples will contract to well below their historic average. This does not mean we expect stock prices to fall – it means we expect them to grow at a slower rate than corporate profits.

Even with the stock market’s troubles during March, the S&P 500 index still posted a first-quarter year-on-year gain of 8.8 percent. This will prove about 3 percentage points higher than underlying profit growth, perhaps not that significant though the fourth-quarter also saw a 3 percentage point gap. These mark only the third and fourth times during the expansion that year-on-year share-price appreciation has exceeded profit appreciation. It’s also, as highlighted by the red arrows, the first back-to-back overshoot on the chart. Given the stock market’s current rally and the modest outlook for second-quarter profits, a third straight overshoot may be in the works.

The trend during this expansion has been exactly in accordance with our thesis – in all but three of the past 20 quarters (and probably a bit more) stock prices have indeed underperformed corporate profit growth. At this point, we are approaching historically average valuations (though some would argue that we aren’t even that far along).

Will the stock market break away from the cyclical valuation patterns, and now simply match profit growth – forever trading at the average valuation? We doubt it. We think the average valuation will continue to represent an equal number of observations that are above average and below average. And that means we still think the odds are for below-average observations ahead.

Still, it is important to keep track of predictions and to recognize when reality is not living up to the forecast. So far, we are inclined to think the recent trend is noise. But a couple more quarters of stock gains exceeding corporate profit growth would justify taking a much harder look at our cycle thesis. In the meantime, though, we remain cautious.

We have written about the apparent long-term valuation cycles in the stock market, and one of our core beliefs is that right now the markets are in the midst of a long-term valuation contraction. As we have noted in our previous articles, that doesn’t mean the market can’t rise – it just means it is likely to rise at a slower rate than earnings grow. Typically such cycles have not reversed until P/E multiples were in the single digits. Today, there is a different take on the phenomenon presented at Econoday:

Remember back if you will to the days of Y2K and earlier when Alan Greenspan was warning of “irrational exuberance.” Perhaps I was the one elbowing you in the Charles Schwab line. Those were times when there was an opposite play between profits and share prices, when share appreciation greatly exceeded profit growth as will be seen in the final graphs of this short take. The graph below shows the ongoing play between profits and shares.

The green bars are the same as the first graph, representing year-on-year S&P 500 profit growth. The orange bars are year-on-year changes in the S&P 500 index. The left side of the graph shows that the index was contracting even while profit growth was emerging. Growth between profits and stocks then matches up well in late 2003 and early 2004 before stocks begin to lag again. Stock growth has in fact lagged now for 10 straight quarters up to the third quarter where the bars are highlighted. The graph suggests, at the least, that speculative excess is not a threat to the stock market.

Possibly. It depends on what you consider to be rational behaviour. It is one thing to think 15 is a low multiple when the valuation cycle is going up, and quite another to think it is low if multiples are headed lower.

At any rate, the chart shows that in only 3 of the last 22 quarters did the market grow faster than earnings on a year/year basis. The fact that there were a few shows that one or two in a row does not invalidate the multiple-contraction thesis. So that’s our story. And we’re sticking to it.

The celebratory mood triggered by the new closing record for the Dow Industrials quickly gave way to some sobering thoughts. The Wall Street Journal (as summarized by Seeking Alpha) said:

Remember the good old days of 1972? On November 10th, the Dow closed at 995.26, breaking the six-year-plus record of 995.15 from February 1966. Then after peaking at 1051.7 in January 1973, it fell, and took a decade to recover. According to Bollinger Capital Market’s John Bollinger, yesterday’s peak looks all too familiar: “Great bull markets are born from periods of excessively low valuations. All the current cycle has allowed us to do is bring us to just above average valuations.” Plagued by Watergate, inflation, oil woes and recession the 70s turned out to be no picnic. While these days may be better, as the article notes, “It hardly seems like a time for lots of bubbly.”

Well, when you’ve been keeping it on ice for six years you need to drink it sometime. However, Eddy Elfenbein notes that Dow’s cross-town rival the New York Times extended the gloominess back further in time.

Market historians have noted that stocks can take a long time to recover from periods of great excess. The Dow and the S.&. P., for instance, did not return to their 1929 pre-crash peaks until 1954, long after the Depression and World War II ended.

That’s true, but it ignores the effect of dividends–which were quite generous back then–and inflation, which in this case was deflation.

The total return of the stock market in real terms made a new high by 1936, which is surprisingly similar to the period from the March 2000 peak to today. After 1936, the market collapsed again for another five years.
So we have two comparisons of extended bear markets during which the markets moved generally sideways. One was inflationary, the other deflationary. One saw a President resign from office, while the other witnessed history’s longest Presidential term in office.

Which all goes to show why we think it is not so much the fundamentals in play, but the effects of long-term P/E cycles.

We have frequently expressed our belief that stock market valuations are undergoing a long-term contraction. Although many interpret this to mean that we expect lower values (as in a decline in major benchmarks) that doesn’t have to be the case. From 1968-1982 the market traded more or less sideways because the valuations (multiples paid on earnings) declined about as fast as the earnings themselves grew.

Now the theory has gone about as mainstream as you can get, with SeekingAlpha’s summary of the Wall Street Journal indicating that the most famous source of market news has a story on the topic.

Can stock prices continue to rise? Two potential bullish resolutions: 1) Earnings soar, taking prices with them. This is unlikely; we have already seen four consecutive years of strong earnings growth, and profits margins are at record numbers. 2) Earnings remain stable, but investors fork-out ever-higher prices to buy-in to their favorite stocks, driving P/E up. This is similar to what happened in the 1994-2000 run up. But then, a) long-term interest rates were plummeting — today it seems unlikely they can fall much more, and b) there was an insatiable hunger to get into the markets — since dampened by the aftertaste of the ensuing bear. Says Byron Wien, chief investment strategist at Pequot Capital Management, “My view is that both earnings and interest rates will be pushing against you.”

With the Dow Jones Industrial Average well within striking distance of a new high, it seemed an appropriate time to revisit a theme we consider important enough to get right and sit tight. That theme is the concept that the long-term bull market of the 1980’s was due as much to expanding valuations as it was to improving fundamentals. Under this thesis, valuation tends to move in waves over very long time horizons. The chart below, which was taken from Barron’s (via The Big Picture) provides graphic support to the theory. During the flat periods, earnings growth is largely offset by shrinking multiples the market is willing to pay for those earnings.

It is easy enough to argue over where a given valuation expansion or contraction starts and ends. The point is that we aren’t talking about a matter of days or months, but of years. And more than six of them (eight if one looks at broader market indices), which is our current tally in what we believe to be a contraction cycle. The fact that the market is now back to long-term average P/E multiples suggests that the contraction may be halfway through – which would give us the equal number of periods below and above the average necessary to label it “average.”

So, will breaking above the previous record change our opinion that we are in a long-term contraction phase? Not at all. In the last contraction cycle (roughly 1968-1982) the market reached new highs several times. However, it tended not to stay there and the new highs were at lower earnings multiples (P/E ratios) than the previous ones.

The second chart compares the Dow Jones Industrial Average from 1968-1982 with the same index from 2000-Present (Source: Yahoo! Finance). The point is not to say that the monthly returns should exactly overlay each other, but to demonstrate that they are similar. And just as the Dow made new highs five years into the last P/E compression cycle, doing so six years into the current one would hardly invalidate the thesis.

So, do we stubbornly stick to our guns despite whatever evidence may come along to the contrary? Of course not. We merely set a fairly high bar for what will qualify to knock us off a key belief. For example, a close that exceeded the previous high by maybe 10% would be enough to revisit the thesis. In this case, that would mean a close above 12,895 – heck, let’s call it 13,000 because we like round numbers.

Yet even a 13,001 close wouldn’t necessarily invalidate the thesis. Remember, we aren’t predicting a flat stock market so much as that valuations will compress. They may compress at a slower rate than earnings grow, in which case higher stock markets would still fit into the thesis. Or, they could compress at a faster rate than earnings grow and signal an S&P level of 800.

We know that to some extent this thesis is a gloomy one (although it is possible to make money in any kind of market given the right strategy.) We also know that, after six generally difficult years it is tempting to celebrate new technical highs. So by all means, break out the bubbly when the Dow breaks its previous record. Just don’t drink so much that it goes to your head.

Oil prices have fallen as much as $16 from their peaks, their steepest reversal in 16 years, in a correction that traders say may be harder to shake off than past setbacks in the market’s four-year rally.

In percentage terms there have been bigger stumbles on oil’s recent ascent, propelled steadily higher since 2002 by the war in Iraq, soaring Chinese demand, constrained oilfield and refinery production, devastating US Gulf Coast hurricanes, and most recently fears of a disruption to Iran’s exports.

But some say this latest setback — triggered by easing concerns on Iran, a weak storm season and a refocusing on healthy consumer nation inventories — may prove more lasting.

“Even though we’ve retraced certain percentages similar to this, it definitely seems that the market is different now,” says New York-based ABN AMRO broker John Brady. “Other times I saw (the corrections) leading to great buy opportunities, but I don’t necessarily think that this time.”

While our bullish stance on oil was essentially inline with consensus views two months ago, the consensus is now rapidly shifting away. Still, we believe this is part of a multi-year reversal of fortunes for stocks and commodities that is perhaps halfway through, for reasons outlined here and here. For perspective, we consider the last time there was such a reversal – 1982.

We gathered monthly closing prices for the Dow Jones Industrial Average from Yahoo! Finance, and for spot oil prices from the St. Louis Fed. Then, we picked approximate dates for the two reversals – January of 1982 and January of 2000. There are probably more exact dates to choose, but we decided to go with the beginnings of years so as not to be accused of massaging the data. The general trends are what interest us, and they are apparent. Oil’s recent run looks very much like the 1980’s Dow, while the Dow’s recent plodding looks like oil used to. We’d definitely call that a reversal.

The chart also tells us that oil was getting due for a crash along the lines of the 1987 stock market crash. A similar setback from the recent highs suggests a mid-50’s oil price. If history is a guide, investors will look back on that time as an ideal buying opportunity.

So what about the sudden bearishness on the part of followers such as ABN’s Brady? We can again point to similarities with the 1987 crash, as discussed recently in a Fortune column called The Legend of Robin Hood.

The idea behind one of the most innovative and influential philanthropic organizations of our time sprang from one of the more boneheaded macroeconomic calls ever made on Wall Street. Or as hedge fund maestro Paul Tudor Jones tells it, “The biggest error I’ve ever made had the best possible outcome.”

The story begins in the summer of 1987. Stock prices were soaring, but so, too, were interest rates. The then 32-year-old Jones – who had made buckets of money during the go-go 1980s – was getting nervous. That September he told his investors that the stock market reminded him of 1929 and a crash was inevitable.

Even after October’s brutal 23% one-day drop, Jones remained apocalyptic. He called up fellow hedge fund manager Glenn Dubin and pleaded, “It’s happening. We’re going into a great depression. We’ve got to do something about it. I want to start a foundation to help, and I’d like you to be involved.”

If we’re right about the historical pattern rhyming, we wish Brady all the success Tudor Jones has seen, and hope his fears are put to as productive a use.

Eddy Elfenbein comments today on the declining P/E ratio, an issue near and dear to our hearts. Eddy says “I can’t think of a bull market before when price/earnings ratios have declined as the market wore on,” from which we can only conclude he isn’t looking very hard.

He illustrates the phenomenon with a few charts:

The first one shows earnings per share (EPS) rising faster than the S&P 500.

The next shows the effect that has on the P/E ratio.

Finally, he shows that the earnings yield (E/P) on the S&P 500 is now much higher than it was throughout the 1990’s.

On this last point, Eddy says:

Today, the market’s p/e ratio is about 15.6 (based on trailing operating earnings). That works out to an earnings yield of about 6.4% (1 divided by 15.6). The market’s earnings yield has most often been about 1% to 2% lower than the yield on the 30-year Treasury bond. Now it’s 1.4% higher. (Note: This is slightly different from the Fed model which uses estimated earnings).

This seems to be where Eddy is simply looking at a historical data set that just doesn’t go back far enough. While 15 years may appear a long time horizon, comparing the bear market of the early 2000’s to the bull market of the 1990’s simply is inadequate. One must go back at least as far as the previous bear market of the 1970’s to even begin to make comparisons.

Which is why we went to an obscure (sarcasm) text called The Intelligent Investor (affiliate link) by Benjamin Graham to source our last image, the table appearing below. It appears on page 71 of the revised edition.

To start with, we note that Graham did not consider a single year’s earnings when comparing stocks to bonds, but rather a trailing three year average earnings yield. This alone would make Eddy’s comparisons look more expensive. Simply by eyeballing the earnings chart we can ballpark trailing three-year earnings at around $70 – giving us an earnings yield for comparison purposes of roughly 5.4%.

Secondly, we can evaluate whether earnings yields higher than bond yields are particularly unusual in the historical context. Is a 1% to 2% discount to bond yields “normal?” Since Graham’s table uses the AAA corporate yield as its benchmark, we gather the same data from the Federal Reserve to get a bond rate of 5.64%, which was the average rate on AAA bonds for the week of August 4, 2006.
Now let’s compare the current difference between the earnings yield and the bond yield to Graham’s historic data. Today the earnings yield/bond yield is approximately 0.96, which is closest to the level in 1958. In two of the sample years it was lower, in three it was higher – in two cases significantly so.

Call it behavioral patterns (as bear markets continue we increasingly distrust stocks) or long-wave cycles (Elliott wave theory) or whatever you want. But increasingly research shows that P/E ratios tend to run in long (15-20 year) cycles of expansion and contraction. So knowing the current P/E is not enough to tell you whether the time is right to buy stocks. You also need to know whether the P/E next year is more likely to be higher or lower.

Jesse Livermore was perhaps the most famous stock trader of the early 20th century; he made and lost millions of dollars in his day. And, for the record, that was a lot of money 100 years ago. Livermore was most famously immortalized in Edwin Lefevre’s thinly veiled biography Reminiscences of a Stock Operator, probably one of the best and most helpful books on trading and investing ever written.

One of Livermore’s trading rules was “Be right and Sit Tight.”
He also said this is one of the hardest lessons for any investor to learn. In other words, Livermore suggested jumping on board a major trend and then having the courage to hold on to make the really big gains.

Clearly, energy is just such a major trend. As I’ve outlined on numerous occasions in The Energy Strategist, demand for oil and gas is booming while the world’s ability to expand supplies and production is, at best, limited. The great commodity bull markets throughout history have lasted for at least 15 to 20 years–this current up-cycle has more than a few good years left in which to run.

But that doesn’t mean there won’t be corrections. Long-term readers are well aware that we’ve seen three significant energy corrections during the past 12 months. Each pullback lasted between one and three months and resulted in prices 15 percent to 25 percent off the highs for most stocks in the group. Each pullback also represented an excellent buying opportunity as the group subsequently rallied to new highs.

We agree that the energy market is one place where there is such a trend. The other places we think we are right are the upswing in commodities and the compression cycle in stocks. A big part of our discipline will be sitting tight on these major themes.

On the other hand, when things go too far in one direction or another there may be opportunities for short-term plays. (In our book, those are 3-month to one-year – we are not day traders for the most part.) We want to take advantage of the shorter-term movements, when possible, without violating the overall sit tight principle. That could mean lightening up on positions, writing covered calls or taking shorter-term long positions in certain stocks when we think the time is right.

Fund manager John Hussman’s newsletter this week brought up what for many would be a frightening prospect: that the current fair value of the S&P 500 Index is 800.

The chart below updates my September 12, 2005 study on the S&P 500 as a discounted stream of future dividends. The blue line is the actual value of the S&P 500 since 1900. The green line is the level at which the stream of S&P 500 dividends (including the implied effect of repurchases) would have actually been priced to deliver a long-term total return of 10% to investors, based primarily on the payments that were, in fact, delivered over time (see the original study for details on repurchases, terminal values, and other explanatory notes).

Though we don’t know the exact payment stream that the S&P 500 will deliver from here on out, long-term growth rates for dividends and peak-to-peak earnings on the S&P 500 are remarkably well-behaved and predictable within a narrow range. Using a 6% assumed long-term growth rate of dividends (matching the peak-to-peak historical growth rate of S&P 500 earnings), the index level currently required to deliver a 10% long-term total return to investors would be 652 (the S&P 500 currently trades at 1251.54). More »